10 Feb, 2021

Quality portfolio with long-term returns: How a low-cost Coffee Can helps investors

Creating winning portfolios is a science and an art. Investors, both professionals and the DIY (do it yourself) ones, know that there are no perfect solutions. This is true for momentum as well as value-investors. The problem gets tougher when the stock market is coming out of the Covid-19 crisis and returns are almost 100% up from its March 2020 lows. So, how will you build a portfolio, especially when you are a DIY investor?

In this case, the concept of the Coffee can portfolia (CCP) has the potential to give good results for the long term.

The CCP is a portfolio of high-quality stocks with high return on equity and strong fundamentals. But many times, a CCP comes with a huge cost, which eats into the returns. As often seen in active funds, where high fees are responsible for low returns, a similar eect is seen in the CCP managed by portfolio management service (PMS) rms. Is there a low-cost solution for highcost CCPs? One is obviously the index fund, the other could be some factor funds that are now available in the Indian market.

Understanding Coffee Can Portfolio

Robert G Kirby, a well-regarded investment advisor, is the man behind the concept. Written in 1984, Kirby starts o his well-known Coee Can Portfolio paper by stating, “We all know that in the aggregate, professional money managers do not produce a return superior to that of a broadly-based, unmanaged portfolio.” He goes on to add, “For many investors, institutional and individual, an index fund may well be the best kind of common stock program.”

In the fall of 1993, Warren Buett was asked at Columbia University Business School about the investment companies he admires the most. Buett replied, “I certainly admire Bob Kirby at Capital Guardian. I admire Bill Ruane and his partners at Sequoia. If I were going away for 10 years and I knew Kirby was going to manage it or that Bill Ruane was going to manage it, I would feel very comfortable.”

Kirby was in the league of Ruane and Buett.

While the idea of Coee Can Portfolio is known for a long time, in India it was made popular by Ambit, an institutional broking rm. The then CEO Saurabh Mukherjea along with Rakshit Ranjan and Pranab Uniyal made the concept popular through Coee Can Investing: The Low Risk Road To Stupendous Wealth. The rm oers a CCP through its PMS.

Later, Mukherjea started Marcellus, a PMS rm where he continued to oer a CCP-like portfolio called consistent compounders. The portfolio has managed to perform even during the pandemic.

Between January 31 and March 31, 2020, the Ambit CCP fell 13% when the Nifty was down by 29%. Between April 1 and June 30, the portfolio recovered 8% when the Nifty recovered by 20%. But overall, during the fall and recovery period from January 31 to June 30, the CCP was down by 6% as compared to 15% for the Nifty. So far, so good.

We looked at a short-term period where the CCP has managed drawdowns very well and even when we consider it net of fees, the portfolio has given good returns. But what if you had bought a Quality Factor Fund as a substitute for the CCP? We will come to the answer in a while.

Active CCPs in India

While most of the active CCPs have been consistent for investors, in our quest we decided to simply look at the index and try to understand how much of it can be replicated in the CCP.

The large-cap names that make a regular appearance in a back-test of the CCP on Indian securities are HDFC Bank, HDFC Ltd, Infosys and ITC. Others like Hero MotoCorp, Cipla, Wipro, Concor, Asian Paints, Mahindra, Hindalco (surprise) also make it to the list depending on the year in which one starts.

In India the Active Coee Can is available as a large-cap-tilted portfolio holding most of the “quality” stocks which are available in the index itself. Quality – is an investment style or an investment factor that entails buying a portfolio of stocks having the following characteristics:

  • Consistently high margins (protability)
  • High asset turnover (eicient use of capital)
  • Low nancial leverage
  • Low operating leverage (low xed costs)

The portfolio is also quite concentrated. Debashish Basu of Moneylife says in his review of Coee Can Investing: The Low Risk Road To Stupendous Wealth, “I am not sure whether it will be easy for savers to digest, and actually apply the strategy, when they see some of their holdings lose 50%-60% value in a year when the market is actually up.”

But what if we take the index itself as a proxy for the CCP for the extreme longterm investor?

Consider the following reasons:

DIY: There are no active fund managers for an index, and it is managed by an advisory committee which lays down the criteria in advance. Since there are no fund managers to make active decisions, the costs are extremely low. Index funds are available at an average cost of 10-20 bps. And since they are from the market, you are assured of returns.

Actively passive: The broad diversied index is a close proxy of the market. And there is a small amount of churn. If you see the graphic below, the winners have retained their place in the index over multi ten-year periods. And they account for most of the gains. The losers have melted away and churned out. Diversication: The index is a market proxy and diversied. The Nifty 50 incidentally has 50 stocks – the same Kirby recommended.

Diversication: The index is a market proxy and diversied. The Nifty 50 incidentally has 50 stocks – the same Kirby recommended.

Rubber hits the return road

Now let us see pre-fees (xed fees and performance fee), tax and other transaction costs. Does the large-cap Active Coee Can beat the market proxy? Yes, it does. But what about Buett’s helpers – the fund managers? How much are they going to charge you? Let us assume a xed fee of 2% and performance fee of 20% over a hurdle rate of 10%.

As the graphic above shows, post-fees, the outperformance drops to 1.3% and in three 10-year periods it has even underperformed the Index Coee Can. So, the issue is not with the concentrated Active Coee Can. It is the fees and paying an active fund manager to do it for you.

Now since most investors would nd it diicult to implement and maintain a Coee Can Portfolio what if someone wants to have an “actively passive” Coee Can besides the Index Coee Can?

In India, these are available mostly in the PMS vehicle. However, not anymore. There is a factor-based solution which gives you a quality stock portfolio at a cost of 50 bps. Below we look at eight portfolio iterations which have completed ve or more years.

The Factor Coee Can outperforms the Active Coee Can on average by 0.80%. And we have not even adjusted for fees and tax till now. It also outperforms in ve out of eight iterations.

So why don’t investors just go out and buy the SBI Quality ETF, which we have used as a proxy for Factor Coee Can above.

The ETF fell 18% during the market fall but went up by 19% during the recovery period. Overall, from January 31 till June 30, the SBI Quality ETF was down 6% – – similar to most CCPs prevailing in the market.

Over the last 10 years, the NSE Quality 30 Index, which is the underlying for the SBI Quality 30 ETF, has returned 15.34% as compared to the Nifty 50’s total return of 10.8%. The SBI Quality 30 is a Factor Coee Can proxy available for 0.5% instead of 2% and 20% fee.

Through the quality ETF we are sticking to the core ideas of Robert G Kirby. Kirby was concerned about transaction costs and the fact the fundmanagement industry in aggregate was not able to overcome the drag of 2% fees. The idea of a Coee Can Portfolio occurred to Kirby in the 1950s, when the wife of a deceased lawyer client of his came to him to manage her portfolio which she inherited from her husband.

Kirby saw the list of securities and it struck him that the lawyer had been following all his buy recommendations but had not followed any of his sell recommendations. He would put USD5,000 in every stock ‘buy’ recommendation. He would then put the share certicates in a safe-deposit box and forget about it.

As a result, he had a very skewed portfolio with a number of holdings below USD2,000, several large holdings over USD100,000 and one very large holding worth over USD800,000 in a company called Haloid which later turned out to be “a zillion shares of Xerox”. This was in the 1950s, so this would be about USD7,000,000 in today’s ination-adjusted terms.

Features of Kirby’s Coee Can Portfolio

DIY solution: The Coee Can Portfolio involves no transaction costs, administration costs, or any other costs. He also adds that any moneymanagement organisation with a large amount of assets under management will nd it diicult to beat the S&P by 3% for any time period in excess of 10 years.

Actively passive: Be active in choosing your stocks and once you have chosen them, hold on to them for not less than 10 years.

Diversication: Build an equal-weighted portfolio of 50 stocks. Now the above principles are simple and easy to understand but not so easy to follow over 10 years.

But in spite of the low fees and better returns why is the AUM of the Quality ETF a paltry INR24 crore. Because we buy stories. We like to see who the fund manager is. And funds are a push and not a pull product in India. Real estate and gold are what we buy as Indians. Because the stories are robust there, they are tangible products, and it enhances our social standing. Who cares if you own a Quality ETF versus homes over the country?

As Morgan Housel says, “Finance is not the study of money. It is the study of what decisions we make with money. And we make emotional decisions about money.”

Behavioural edge: Commitfor the long run

Kirby was not a major proponent of indexing, but he noted that most investors do not have the “perspective, patience and courage” to actively invest in equities. His Coee Can paper tagline is — “you can make more money by being passively active than actively passive”. This was true in the 1950s when he started his career, in 1980s, when he wrote his paper and even now in 2021. Very less investors have stuck around to reap the gains of long-term performance. AMFI data shows that most investors stop their SIPs within 2-3 years of starting one and this interrupts compounding.

Kalpen Parekh, CEO of DSP Mutual Fund, recently tweeted that their longest running mutual fund scheme had completed 24 years. And guess how many investors had remained invested through the period? Less than 24. HDFC Balanced Fund also has had a similar experience.

If you are a “ll it, shutit, forgetit” kind of investor who doesn’t wantto review portfolios regularly or contend with style drift, fund manager eits, AMC risk et al, go forthe Inde Coee Can via the Nifty 50 Inde Fund or ETF. It will stay true to its mandate; it will deliver marketreturns and will not have other unintended surprises.

Also, strictly speaking, an index is not passive. It is an organic rules-based portfolio with a simple criteria which is implemented, come dotcom bubble, pandemic or housing bubble. It is rebalanced on a semi-annual basis with names of inclusions and exclusions being announced four weeks in advance.

“Simplicity is the ultimate sophistication,” said Leonardo da Vinci. If you have a day job and are investing to meet a goal like retirement corpus, education fund for your children or just saving for nancial freedom, focusing on asset allocation and keeping it simple is your best shot at meeting your goals.

If you are trying to be the best lawyer or surgeon out there on weekdays and being Jim Simons, George Soros or Warren Buett on weekends, you are a roadkill. Unless you are DeepF***ingValue and rode the Gamestock rally.

(The author is the managing partner and principal oicer at QED Capital Advisors.)

(Graphics by Sadhana Saxena)